Derived from Section 1031 of the Internal Revenue Code, a 1031 exchange allows a taxpayer to sell income, investment or business property and replace it with a like-kind. property (Elizabeth Weintraub, The Balance). Say you purchased an investment property for $50,000, and after 5 years you were able to sell it for $100,000. Rather than pay the capital gains tax, which is either 15% or 20%, you may defer payment by purchasing another property of similar value within an aloted time frame.
This is a great tool that investors use to build their portfolio of investment properties. Instead of relinquishing that profit to capital gains tax, you can instead put that profit towards a property with even greater investment or earning potential. You have more capital to leverage to acquire more or larger properties.
So, how long to you have to purchase another property after selling the original property? First, you must identify in writing a potential replacement property within 45 days from the closing and transfer of the original property. Secondly, you have to close on the new property within 180 days of closing on the original property.
There is no limitation on how many exchanges you may do with investment property over the years. In fact, you may continue to implement the 1031 exchange strategy until you pass away and the property is inherited by your heirs. If your heir decides to sell such a property after your death, they won’t have to pay a capital gains tax. The replacement property will have a stepped-up basis equal to the property’s fair market value. As a result, the deferred gains are effectively eliminated and you are allowed to pass on all of your capital gains to your heirs tax free (Joe Fairless, 2019). Therefore, in addition to providing you more capital to acquire larger properties, the 1031 exchange strategy is also a great legacy building tool.
See the following link to the IRS Form: https://www.irs.gov/pub/irs-pdf/f8824.pdf